But the cost of debt capital is only one factor influencing deal flow. More important than the cost of debt is its availability, Levy says. "Of course, availability and cost are linked. If the cost of debt exceeds certain levels, it isn't truly available," he points out. "The fact that multifamily debt remained largely available through the depths of the recession while it did not for the other asset classes is one of the reasons why values in multi-housing didn't bottom out as much and bounced back faster."

While the cost of debt capital has dropped dramatically over the past year-with the exception of multifamily housing, where the agencies have kept debt capital fl owing throughout the country-it really has been available in volume only for core deals in the best markets. "More recently," Levy says, "debt has become more available in secondary markets and for transitional (or value-add) deals and, because of this, we are beginning to see more trades of these types of deals."

These are a sampling of the impact of interest rates on deal flow. Los Angeles based Mark Bolour, CEO and principal of Bolour Associates, echoes Johnson's observation that the low interest-rate environment has allowed borrowers to meet debt service with low occupancies and low rents. "For us, this environment has stifled deal volume," he says.

Outside of distress, however, low interest rates were responsible for much of the improvement in the investment markets in 2010, according to Bob White, president and founder of Real Capital Analytics in New York City. He says interest rates could rise in 2011, since 10-year US Treasury rates are up (which might ordinarily mean that cap rates would rise too). But rising T-rates won't necessarily mean that cap rates will also rise.

"Rising interest rates would certainly put upward pressure on cap rates, but there will not be a one-to-one relationship," the RCA president says. "Much of how cap rates react will depend on why interest rates are going up in the first place, but in the most likely scenarios, the correlation between interest rates and cap rates will be low. Moreover, there is a cushion in the spreads of both property yields and mortgage rates that can absorb much of any initial increases in base rates, and possibly allow cap rates to fall a bit more if the rise in interest rates is not too steep."

White continues that current spreads for commercial properties are 500 bps or so (400 bps for multifamily), which he says "reflects a high degree of risk considering the market is coming off the bottom of a cycle, with an improving outlook. That leaves about 150 bps of give until the spread reaches the historical average closer to 350 bps."

Confidence that spreads will contract before cap rates rise is clear in the growing supply of capital for commercial property, says White. "Competition among both buyers and lenders is growing with surprising speed, reflecting increasing investor interest across a broad array of capital sectors," he says. Amid all of the analysis of how interest rates will affect distressed-asset transactions as well as overall deal flow, there is the never-ending discussion about when and how much rates are going to rise. This uncertainty is one of the factors that industry analysts almost always cite when forecasting future deal flow.

Most agree that rates, although going up, will remain low by historical standards-below 5%. "Interest rates are affected by just too many variables to know for sure, including inflation, currency risk and even other countries buying our debt as both a ‘reserve currency' or safe haven, or perhaps to have political power and influence," explains Johnson Capital's Johnson. "As long as deflation is a concern, and we still have high unemployment and world chaos, US interest rates should remain low," he says. His prediction is a gradual rise next year as the economy recovers and the US budget deficit finally affects Treasury investor expectations.

Brent Sprenkle, an associate partner in the Los Angeles office of Hendricks & Partners, expects that in the short term, interest rates will be relatively stable, but in the long term, they will rise, especially if the stock market continues to improve. "Lending institutions have plenty of business right now providing debt, and there hasn't been much resistance with higher rates in the past two months," Sprenkle points out.

Another factor pointing toward higher rates is the need to finance government debt, notes William Hughes, senior vice president and managing director in the Newport Beach, CA-headquarters office of Marcus & Millichap Capital Corp. "In the long run, there is going to be upward pressure on interest rates as the economy improves," Hughes says. However, he points out that risks in the marketplace could produce temporary declines. "To the extent that the economy doesn't rebound in a manner that we think it will, we could see some temporary declines."

Hughes expects an increase of 50 basis points over the next 12 months, which he says is dependent on the strength of the economy moving forward and to what extent the government stays committed to keeping rates low. "We think the 10-year Treasury will remain between 3.4% and 4% over the next 12 months," he says, which means that he expects increases, but they will be small. "Government intervention will tend to keep interest rates in their current ranges during the next 12 to 24 months."

From the standpoint of impacting sales velocity, MMCC's Hughes says that interest rates have driven an increase in sales velocity over the past quarter. However, he says that low interest rates have also been a contributor-particularly for the best-of-class assets-to declining cap rates. "They have both a positive and negative effect on volume," he says.

Rising interest rates would force more commercial property owners into default and foreclosure or selling to avoid foreclosure, according to Bolour. "Banks would also be forced to sell notes or offer discounted payoff s to borrowers," he says.

Michael Williamson, co-chair of the real estate practice group at law firm Buchalter Nemer in Los Angeles, believes that increased rates will have only a marginal impact on deal flow.

Other equally important factors in financial real estate transactions are debt coverage ratios (helped by low rates); loan to value (indifferent to interest rates); loan to cost; and amortization schedules.

Hughes points out that "higher interest rates put pressure on cap rates, obviously, as a higher cost of capital reduces cash-on-cash returns. "That said, over the next 12 to 24 months, interest-rate movement will have a negligible impact on property values." Levy adds that higher rates will also have a negligible impact on deal flow. "When interest rates inevitably rise," he says, "it will likely be associated with material improvement in fundamentals. As such, people will be able to underwrite with more certainty and pay more for the same assets even if the cost of capital were to rise."

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